Investment Theory and Risk Management, + Website

Price and Dividend Multiples

Price to earnings (p/e) and its reciprocal (e/p) along with the dividend yield (d/p), where p is share price and e and d are earnings per share and dividend per share, are common multiples scrutinized by equity analysts and, as we shall see, have many applications. The concept of value stocks, for example, are stocks with low p/e ratios. The value is in the belief that the price is too low for the stated earnings per share and will therefore mean-revert earning the holder a greater return. Growth stocks, on the other hand, are stocks in companies whose earnings have shown high growth in the past and are expected to grow at above-average rates going forward. Growth companies are therefore those believed most capable of expanding earnings and revenue.

The growth and value concepts have spawned an industry in what is called style analysis—small versus big capitalization stocks and value versus growth. The original research was presented in a series of seminal papers by Kenneth French and Eugene Fama, who suggested the existence of certain style factors to supplement the single market index in the capital asset pricing model (CAPM). We will derive the CAPM in the next chapter. The point made here is that fundamental factors on market capitalization (size), and multiples describing book value to market value and earnings to price (value and growth) are instrumental in price determination. Figure 4.1, for example, is from French's website and describes how ...